This paper aims to study stock price adjustments toward fundamentals due to the existence of arbitrage costs defined as the sum of transaction costs and a risky arbitrage premium associated with the uncertainty characterizing the fundamentals. Accordingly, it is shown that a two-regime STECM (Smooth Transition Error Correction Model) is appropriate to reproduce the dynamics of stock price deviations from fundamentals in the G7 countries during the period 1969-2005. This model takes into account the interdependences or contagion effects between stock markets. Deviations appear to follow a quasi random walk in the central regime when prices are near fundamentals (i.e. when arbitrage costs are greater than expected arbitrage profits, the mean reversion mechanism is inactive), while they approach a white noise in the outer regimes (i.e. when arbitrage costs are lower than expected arbitrage profits, the mean reversion is active). Interestingly, as expected when arbitrage costs are heterogeneous, the estimated STECM shows that stock price adjustments are smooth and that the convergence speed depends on the size of the deviation. Finally, using two appropriate indicators proposed by Peel and Taylor (2000), both the magnitudes of under-and overvaluation of stock price and the adjustment speed are calculated per date in the G7 countries. These indicators show that the dynamics of stock price adjustment are strongly dependent on both the date and the country under consideration.

This paper relaxes a fundamental hypothesis commonly accepted in the expectation formation literature: expectations are, unchangingly, either rational or generated by one of the three simple extrapolative, regressive, or adaptive processes. Using expectations survey data provided by Consensus Forecasts on six European exchange rates against the US dollar, we find that the rational expectations hypothesis is rejected at the aggregate level. By implementing a switching-regression methodology with stochastic choice of regime, we show that the expectation generating process is given at any time by some combination of the three simple processes. An interpretation of this framework in terms of economically rational expectations is suggested. Copyright � 2007 The Authors; Journal compilation � 2007 Blackwell Publishing Ltd.